Depreciation Challenges for “Flip-Flop” Conformity States

Ellen Barker, CPA
Subject Matter Expert – Software
Bloomberg Tax & Accounting

Keeping up with tax law at the state level has always been challenging for corporate taxpayers, especially because states do not consistently conform to the Internal Revenue Code (IRC). The recent passage of the 2017 Tax Cuts and Jobs Act (TCJA) added to this challenge by creating significant uncertainty regarding the states’ response to “full expensing” (i.e., the new 100% bonus depreciation rate). States that have gone back and forth between conforming and not conforming with federal bonus depreciation (“flip-flop” states) present added complexity for taxpayers because of differing treatment across years. In particular, calculating federal to state depreciation modifications and adjusted basis differences for gain or loss determination becomes even more difficult in these states.

Calculating modifications for state compliance reporting

To compute state taxable income, most states use federal taxable income as a starting point. However, each state imposes certain addition or subtraction modifications to arrive at state taxable income. For states that do not conform to bonus depreciation, and therefore require related addition and subtraction modifications, compliance can be particularly difficult. Keeping track of these modifications over time is critical because the additions and subtractions change each year and ultimately sum to a net modification to state taxable income.

In addition, many states require corporate taxpayers to file additional state tax forms, which in turn require detailed supporting documentation that can be burdensome. Some states require the reported modifications to be broken out by type of depreciation (e.g., Section 179, bonus depreciation, regular MACRS) whereas others require a single modification amount to reconcile the difference between the total federal and state depreciation. While some states will have their own unique depreciation schedules, others require taxpayers to complete a separate Form 4562 for state depreciation purposes as if bonus depreciation had not been claimed.

[Learn how you can calculate state bonus depreciation with ease]

For example, Oregon did not conform to federal bonus depreciation for tax years 2009 and 2010. While this decoupling generally only affected qualifying property placed in service during 2009 and 2010, the impact of this temporary non-conformity plays out in subsequent tax years through modifications.

Let’s look at an example with the following facts:

For tax years 2009 and 2010, Federal allows 50% bonus whereas Oregon doesn’t allow bonus.

Asset #1

  • Cost: $300,000
  • Recovery period: 3 years
  • Depreciation method: Straight-line
  • Placed-in-service date: January 1, 2009
  • State depreciation expense per year: 100,000 [300,000/3]

 

Asset #2

  • Cost: $750,000
  • Recovery period: 15 years
  • Depreciation method: Straight-line
  • Placed-in-service date: January 1, 2010
  • State depreciation expense per year: 50,000 [750,000/15]
addition and subtraction modifications in subsequent tax years

Taxpayers often keep track of these modifications in Excel spreadsheets. The maintenance of these workpapers is generally a manual effort and can be extremely time-consuming and cumbersome, especially when the taxpayer files in many states. Maintaining separate depreciation books for each state with the correct bonus depreciation configurations by period may be one way to help tackle this challenge.

This approach enables taxpayers to compare the detailed depreciation differences from the federal and state books without manually tracking and accumulating modifications from year-to-year. However, maintaining separate books in Excel can still be a very manual and time-consuming effort. Investing in a software that automates the state depreciation calculations using built-in tax laws can significantly reduce risk and time spent on updating manual Excel calculations across the many states where this is an issue.

Tracking adjusted basis for gain/loss determination

In general, the adjusted basis of an asset is its cost reduced by the depreciation allowed or allowable over the life of the asset. For purposes of determining regular depreciation under the Modified Accelerated Cost Recovery System (MACRS), an asset’s adjusted basis is first reduced by the bonus depreciation amount.

Consequently, a state not conforming to (i.e., disallowing) bonus depreciation causes federal and state adjusted basis differences. Maintaining accurate records is especially important because, on disposal, any accumulated basis differences will result in a difference between the gain or loss reported at the state and federal levels. Instead of tracking modifications to state depreciation over time to arrive at state adjusted basis, maintaining a separate state depreciation book can reduce reconciliation times and help to ensure accuracy.

Let’s look at an example with the following facts:

  • Cost: $1,000,000
  • Recovery period: 7 years
  • Depreciation method: 200% declining balance
  • Placed-in-service date: January 1, 2017
  • Disposal date: December 31, 2018
  • Disposal proceeds: $800,000
  • The state in question does not conform to bonus depreciation
computation adjusted basis 12 31 2018
Gain Computation Differences Tax Year 2018

States with “Flip-Flop” Bonus Conformity

The following is a list of states that have historically “flip-flopped” conformity. Taxpayers should determine whether there are any depreciation impacts in open tax years and continue to monitor these states due to the complexity.

States Flip Flop Bonus Depreciation Conformity to Federal Based on Placed Service Dates
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